Economic Outlook in 2010

Economic Outlook in 2010 Presented to: Institute of Internal Auditors April 1, 2010 Harvey Rosenblum Executive Vice President & Director of Research Jessica Renier Senior Economic Analyst Federal Reserve Bank of Dallas The views expressed in this presentation are strictly those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or of the Federal Reserve System.

Inflation or Deflation, Tell me if you can. Will we be Zimbabwe Or will we be Japan? -Merle Hazard

Where We Are Currently Base of Stabilization Two quarters of GDP expansion Manufacturing, services, IP expanding Employment about flat; Temps increasing Consumption rising, discretionary spending still weak Negative Surprises Home sales dropped over last three months Consumer confidence faltered anew

How Did We Get Here?

IMF World Economic Outlook: What a Difference a Year Makes One Year Ago: 2009 Forecast % annual rate 6 5 4 IMF 3.0 3 2 HR 1 0.2 0-1 -2 2005 2006 2007 2008 2009 Source: IMF World Economic Outlook, Oct. 08/ 09

IMF World Economic Outlook: What a Difference a Year Makes One Year Ago: 2009 Forecast % annual rate 6 5 4 IMF 3.0 3 2 HR 1 0.2 0-1 -2 2005 2006 2007 2008 2009 Source: IMF World Economic Outlook, Oct. 08/ 09 Current: 2010 Forecast % annual rate 6 5 4 3 2 1 0-1 -1.1-2 200520062007200820092009 IMF HR 3.1 3.0 2010

GDP and Inflation Real GDP Growth SAAR, % change 8 6 4 2 0-2 -4-6 -8-6.4% 2007 2008 2009 5.6% Low-to-Moderate Inflation % Yr/yr 6 Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Dallas Fed 5 4 3 2 1 0-1 -2-3 Headline CPI Core CPI Trimmed Mean PCE July 2009 2007 2008 2009

Job Market Seems About Flat Change, thousands 400 200 0 Payroll employment -200-400 -600-800 -1000 Total jobs lost: 5.9 million -753 Mar 09 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Source: Bureau of Labor Statistics

Job Market Seems About Flat Change, thousands 400 200 0-200 -400-600 Payroll employment +64 Feb 10-26 -36-109 -107k -800 Total jobs lost: 8.4 million -1000 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Source: Bureau of Labor Statistics

U.S. House Price Index (Case-Shiller) Percentchange 2.0 1.5 1.0 0.5 0.0-0.5-1.0-1.5-2.0-2.5-3.0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: S&P, Fiserv, MacroMarkets LLC Jan 10 0.4% Jan 09-2.0% Note: Composite 10-City Index

Consumers Still Very Concerned About Present Economy Index 200 180 160 140 120 100 80 60 40 20 0 Source: The Conference Board Present Conditions Future Expectations Mar 09 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

Consumers Still Very Concerned About Present Economy Index 200 180 160 140 120 100 80 60 40 20 0 Source: The Conference Board Present Conditions Future Expectations '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 Mar 10 70.2 26.0 Lowest since 1983

Industrial Production and Capacity Utilization SA, Percent of Capacity 90 85 Industrial Production Index, 2002=100 120 110 80 Total Industry Capacity Utilization 98 100 90 75 80 70 65 70% Mar 09 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 Source: Federal Reserve Board 70 60

Industrial Production and Capacity Utilization SA, Percent of Capacity 90 85 80 75 70 Total Industry Capacity Utilization Index, 2002=100 120 110 Industrial Production 101 Feb 10 100 90 80 73% 70 65 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 Source: Federal Reserve Board 60

Stock Market Plunged Dow Jones 30 Jan. 4, 2007=100 115 105 95 85 75 65 55 45 Mar. 9, 2009 35 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Source: Dow Jones

And Has Since Recovered. Dow Jones 30 Jan. 4, 2007=100 115 105 95 85 75 65 Mar. 19, 2010 +64% 55 45 Mar. 9, 2009 35 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Source: Dow Jones

Interbank Frictions Mostly Gone Percent 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 3M LIBOR Expected Fed Funds Mar 18, 2009 1.08 0.0 Jan-07Apr-07 Jul-07 Oct-07 Jan-08Apr-08 Jul-08 Oct-08 Jan-09Apr-09 Jul-09 Oct-09 Jan-10 Source: Financial Times, Reuters

Interbank Frictions Mostly Gone Percent 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 3M LIBOR Expected Fed Funds Jan-07Apr-07 Jul-07 Oct-07 Jan-08Apr-08 Jul-08 Oct-08 Jan-09Apr-09 Jul-09 Oct-09 Jan-10 Source: Financial Times, Reuters Mar 19, 2010 0.09

Junk Spreads Near Pre-Crisis Levels Percent 22 20 18 16 14 12 10 8 6 4 2 0 Irrational Complacency Financial Turmoil Junk 7yr Treasury Junk AA Long-run average: 4.9 Junk-7yr Treasury Jan-07Apr-07 Jul-07 Oct-07 Jan-08Apr-08 Jul-08 Oct-08 Jan-09Apr-09 Jul-09 Oct-09 Jan-10 Source: Merrill Lynch, Moody s, Federal Reserve Board Financial Panic 5.5 3.0

The Credit Overshoot Has Not Been Unwound BANK LOANS AS % OF GDP 50% 50% TREND LINE 40 40 30 1.4 1.2 1.0 0.8 HOUSEHOLD DEBT-TO-INCOME RATIO TREND LINE Source: BCA Research 2010, Martin Barnes 1980 1985 1990 1995 2000 2005 2010 30 1.4 1.2 1.0 0.8

A Look At The Region

Texas Business Cycle Index Suggests that Recession is Over M/M SAAR 12 10 8 6 4 2 0-2 -4-6 -8 82 88 94 00 06 M/M SAAR 12 10 8 6 4 2 0-2 -4-6 -8

Texas Manufacturing Outlook Survey Shows a Rebound in Activity Index 60 40 20 0-20 -40 Production Volume of New Orders Volume of Shipments Capacity Utilization -60 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10

Dallas District at Front of the Pack in the Current Recovery SAAR 0.5 0.25 0.0-0.5-1.0-0.06-0.56-0.78-0.84-1.06 (3 months ending in Jan. / previous 3 months, annualized job growth by Fed District) -1.5-2.0-1.19-1.24-1.41-1.42-1.48-1.72

A Look At Banking

Loan Growth Percent, Yr/yr 20 15 10 5 0-5 -10 2005 2006 2007 2008 2009 U.S. -5.0% 11 th District -4.1% Note: Data for 11 th District banks have been adjusted to include Comerica in all time periods and exclude Wells Fargo Bank South Central.

Percent, Yr/yr 20 15 Loan Growth Banks with Assets < $1 Billion 10 5 11 th District 1.5% 0-5 U.S. -4.1% -10 2005 2006 2007 2008 2009

Banks Close to Beginning an Easing of Credit Standards Percent tightening standards 100 80 60 40 Commercial loans (large and medium firms) Q4 08 20 0-20 Consumer loans Q1 10-40 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 Source: Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve Board)

Number of banks, or $ Billions 800 700 600 500 400 300 200 100 0 Source: FDIC But, High Number of Problem Institutions on the FDIC s List 53 61 65 76 90 117 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2007 2008 2009 171 252 305 416 552 702 Assets of problem banks $403 B

Monetary Policy

Rosenblum s First Law For every Federal Reserve policy action, there is an equal and opposite criticism.

Billions $ 2450 2200 1950 1700 1450 1200 950 700 450 200 Week ended: Special Credit Facilities Fed Balance Sheet Outstanding: Economy Still on Life Support $1,020 TSLF Treasurys Fed Agency $894 $2,426 TSLF Treasurys Special Credit Facilities $2,247 $2,144 Fed Agency $2,051 $2,216 Fed Agency Sep. 3, 2008 Dec. 31, 2008 Mar. 25, 2009 Jan. 6, 2010 TSLF MBS Treasurys Special Credit Facilities MBS Treasurys TSLF $2,199 Special Credit Facilities Source: Federal Reserve Board

Inflation is Muted Due to Lots of Excess Capacity TRIMMED MEAN PERSONAL CONSUMPTION EXPENDITURES INFLATION RATE 3.0% 3.0% 2.5 2.0 1.5 2.5 2.0 1.5 NFIB PLANNED PRICE HIKES 30% 30% 20 20 10 0 Source: Dallas Fed, NFIB and BCA Research 2000 2002 2004 2006 2008 2010 10 0

Inflation Expectations Subdued SA, Percent 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0-1.5 10-year TIPS inflation expectations 5-year TIPS inflation expectations March 09 1.1 0.6 2003 2004 2005 2006 2007 2008 2009 2010 Source: Federal Reserve Board

Inflation Expectations Subdued SA, Percent 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0-1.5 10-year TIPS inflation expectations Feb 10 2.3 5-year TIPS inflation expectations 2.0 2003 2004 2005 2006 2007 2008 2009 2010 Source: Federal Reserve Board

Timing of Exit Strategies FOMC will focus particularly on anticipated resource utilization, inflation and inflation expectations in its decisions on exit timing Fed has no prior experience in creating or removing monetary stimulus of this magnitude and diversity

A Humble Note The way events have unfolded over the past few months simply has no precedent No one knows the outcomes of an unprecedented event. No one. Zachary Karabell The Economic News Isn t All Bleak Wall Street Journal Dec. 26, 2008, p.a13

Economic models are like bikinis: what they reveal is suggestive, but what they conceal is vital. -John Cassidy

Economic Conclusions Economy gaining some traction Monetary policy inflationary Economy riddled with deflationary forces Inflation not an immediate concern Time to develop and implement exit strategies

Back of Tray

Forces Working to Spur Profits, Not Inflation SA, % change, year-ago 10 8 6 4 2 0 Compensation per hour Lowest since 1949 0.8-2 -4-6 Unit labor costs '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 Source: Bureau of Labor Statistics Record low -4.7

Manufacturing Orders 50+ = Expanding 75 70 65 60 55 50 45 40 35 30 25 20 15 ISM New orders 1997199819992000200120022003200420052006200720082009 Source: Institute for Supply Management Feb 10

The World of Finance: What a Difference a Year Makes S&P 500: +68% Junk spread: -12.5 percentage pts. Libor-OIS: -1.0 percentage pts. 10yr-1yr Treasury: +1.1 percentage pts. --------------------------------------------------------------------------------------------------------- Credit card rates: +1.6 percentage pts.

FOMC Exit from Extraordinary and Massive Monetary Stimulus Drop phrase likely warrant exceptionally low rates for an extended period. Allow special liquidity facilities to expire Many have expired as of Feb. 1, 2010 TALF will soon expire End large-scale asset-purchase programs Scheduled to end by end of 2010 Q1 with slowing pace of purchases announced

Use in combo. to increase Fed funds rate FOMC Exit from Extraordinary and Massive Monetary Stimulus (Cont.) To reduce the credit-growth and money-growth potential of the current $1.1 TRILLION of excess reserves: Begin reverse repurchase agreement program Raise interest rate on excess reserves Establish a Fed term-deposit facility for banks Outright sales of assets

Timing of Exit Strategies Depends on: Long time lags for monetary policy to impact economic growth and inflation Forecasts of when economy will return to more normal patterns Cannot wait for return to actual high resource utilization

Texas Jobs Declined at a Similar Pace as the Nation in 2009 Dec/Dec, 5 4 3 U.S. Texas 3.1 2 1 0.8 0.4 0.5 0-1 -0.3-2 -3-4 -2.6-3.2-3.5 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Texas Exports Increasing Index, SA Real Jan. 2000=100 200 180 160 140 Texas 120 100 80 U.S. minus Texas 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Texas vs. Other States Leading indicators turning positive in most states: Housing permits Initial claims Exports Consumer confidence State budgets Jobs declined in all states in 2009: But declines have narrowed 11 th District at head of pack

Bank Loan Growth Percent of Banks Increasing Lending in 2009 Percent 80 70 70% 60 57% 50 40 30 20 10 0 42% < $1B in Assets, U.S. > $1B in Assets, U.S. < $1B in Assets, 11th District 46% > $1B in Assets, 11th District

Long-Term Willingness of Banks to Make Consumer Loans is Increasing Percent 80 60 Net Percentage of Banks More Willing to Make Consumer Installment Loans 40 20 more willing Q1 10 0-20 less willing -40-60 Q4 08-80 Source: Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve Board)